Market Discussion, Recent Crash History, BBB Spreads

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Market Discussion, Recent Crash History, BBB Spreads

Three “Data” items today:

Topic #1: Friday’s market action in the context of our VIX playbook:

  • The VIX closed at 28.9, right on top of the 28 level we’ve been telling you is significant since it is 1 standard deviation (8 points) away from the long-run mean (20).
  • That is the highest close for the VIX since December 3rd (30.7). The S&P 500 rallied 5.7 percent from that date through January 3rd, 2022, so we are in the neighborhood where the VIX has recently signaled a near term bottom.
  • In the last year the VIX also hit our 2 standard deviation threshold (36) once, on January 27th, 2021 with a close of 37. The S&P rallied by 4.9 percent over the next 3 weeks.

Takeaway: we hit the first statistically valid level of market panic on Friday, and recent (1-year) history says 36 is the next VIX level to watch for. If you are trading this market, we continue to advise caution. Clarity on Fed policy will not come until Wednesday’s FOMC meeting, and even then commentary from the Fed and Chair Powell may be insufficient to calm investors. If we were running a trading book here, we’d only be nibbling at a 28 VIX and saving plenty of capital to scale into positions if and when the VIX hits 36, 44, and (in a true meltdown) 52.

Topic #2: Crash playbook, 2020 version. We’ve written a few times about the possibility of a “crash” in US large cap stocks, which we define as a day when the S&P 500 is down more than 5 percent. That is a 5 standard deviation move, sufficiently unusual to merit calling it a crash.

Two points worth your attention about the recent history of down +5 percent S&P 500 days:

  • There were no 5 percent down days during the December 2018 market decline (S&P 500 down 15 percent that month, peak to trough) caused by fears of excessive Federal Reserve monetary policy tightening. The worst days were December 4th, down 3.2 percent, and the low print for the month (December 24th, down 2.7 percent).
  • There were, however, five down 5 percent days in 2020: March 9th (-7.6 pct), March 12th (-9.5 pct), March 16th (-12.0 pct), March 18th (-5.2 pct) and June 11th (-5.9 pct). All were excellent entry points in terms of allocating fresh capital to US stocks across even a short horizon (3 months to a profit, in the case of March 9th, and shorter for the rest).

Takeaway (1): if US stocks are “only” worried about a Fed policy mistake, then recent history says we should NOT see a down +5 percent day for the S&P 500. If one does occur, then we know two things. The first: there is some larger issue roiling markets that will require a fiscal and/or monetary policy response to address. The second: as long as the nature of that response is easy to define, a down 5 percent day can be a good buying opportunity.

Takeaway (2): one or several down +5 percent S&P 500 days would essentially signal that 1) a US recession this year has become very likely (bad, obviously) and 2) this would be enough to cool inflation without the need for Fed rate hikes (good). That, in a nutshell, is why buying “crash” days is something to consider. To be clear, we are not calling for a crash but it’s always better to plan ahead than to wonder what to do after the fact.

Topic #3: A look at BBB US corporate bond spreads. When the Federal Reserve puts together its annual Dodd-Frank stress test scenarios, it always includes a handful of market-based measures along with the usual economic indicators. Last year, these were: 3-month as well as 5- and 10-year Treasury yields, mortgage rates, the Dow Jones Total Market Index, residential and commercial property prices, the CBOE VIX Index, and BBB bond spreads.

While the Fed obviously looks at many other indicators when it assesses general financial conditions, the fact that BBB spreads are on the Dodd-Frank short list tells us it is an important signal to watch. These are, of course, the marginal piece of the US investment grade corporate bond market since a full-letter downgrade puts them into “junk bond” territory. Moreover, half of the US investment grade bond index is BBB rated.

The chart below shows BBB spreads over Treasuries over the last 5 years. We’ve highlighted how these traded during the November – December 2018 market meltdown over concerns the Federal Reserve would go too far with interest rate hikes. Spreads increased by 42 basis points to 202 bp over Treasuries. Then, during the panic at the start of the pandemic, BBB spreads spiked to almost 500 basis points. That, by the way, it why the Federal Reserve felt it needed to support the BBB market in 2020.

Takeaway: the rightmost part of the chart shows BBB spreads have only increased modestly over the last 4 months and at present levels (123 basis points) do not look anything like either the 2018 or 2020 experience. Why is that important? Because, as much as the recent drop in equity prices may be this market’s way of signaling the risk of a Fed policy mistake, the corporate bond market is still saying everything is OK. And, as we noted at the start of this section, the Fed pays attention to this market.